Rattlesnake Bonds – Listen for the rattle

I was watching the National Geographic Channel and they were discussing the rattlesnake.  It seems that over the course of millions of years of evolution that the rattlesnake has developed an interesting feature.  Most of the time before striking and biting someone, the snake will signal with their distinctive calling card – the rattling tail.  However, once the rattlesnake’s tail has been rattled, all bets are off.  It is a clear sign that danger is lurking.

In the financial services world, I wish that bonds and bond funds came with such a distinct warning.  For although there are multiple warnings available to investors that we may be at the beginning stages of a bond bubble,  the warning signs appear to be too subtle.  This is evidenced by the fact that investors continue to pour money into bond mutual funds.

According to Investment Company Institute (ICI) in January 2018, bond mutual fund flows should exceeded $1.5 Trillion in the year 2017.  The same report showed that individuals withdrew $1.3 Trillion from domestic equity (stock) mutual funds last year.

In the recent 2nd quarter 2018, the trend continued.  Investors sent a net $126.72 billion to bond focused mutual funds and ETFs according to same ICI.  In contrast, mutual funds focused on U.S. stocks saw an outflow of $58.72 billion.

The bond market is wagging its tail:  The reason that bonds are dangerous at this point is that interest rates are low and bond prices so high that there is little room left for gains.  The Federal Reserve has begun to raise interest rates and has forecasted that they will continue to increase the rates this year and most likely next year.

To put it another way, you could purchase a piece of company ownership represented by a stock share and receive nearly the same income as you would lending the company money.  However, the stock also receives the potential added benefit of any stock capital appreciation over the next several decades.

In early June 2018, the average S&P 500 stock annual dividend (monthly) was slightly under 2% (1.84%),  while the average AA rated company bond yield (daily) was just nearly 3% (2.97%).

This is the way the bond market rattles its tail. Be forewarned. 

The loudest noise from the bond market rattling its tail comes from bond math.  Bonds have a term called duration which technically represents a period of time, expressed in years, that indicates how long it will take an investor to recover the true price of a bond, considering the present value of its future interest payments and principal repayment.

Duration is useful in measuring a bond fund’s sensitivity to changes in interest rates. The longer the duration, the more a bond fund’s price will fluctuate with interest rate changes.

To estimate how a change in interest rates can affect the share price of a bond fund, you would multiply the fund’s duration by the change in rates. If a fund’s average duration is 2.5 years, a 1-percentage-point rise in interest rates would lead to an estimated 2.5% decline in the share price. A 1-percentage-point decline in rates would cause an estimated 2.5% rise in the share price.  Most bonds have longer duration than 2 years and thus would have greater potential losses based on the bonds duration.

So what should investors being doing with their money?

What they should always do.  Diversify their overall portfolio holdings and ensure they have enough money allocated to ownership in the great companies of the world known as stocks.   According the Gallop, the percentage of U.S.  households that have financial assets in stock ownership has fallen to approximately 54% in 2017 from as high as 62% in 2008.

A more balanced portfolio approach is required for most individuals so they may be able to achieve the various goals that they have set for themselves while attempting to maintain their purchasing power.  Consider yourselves forewarned – listen for the rattle!

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